Alert April 02, 2015

Recent SEC Enforcement Actions Renew Focus on Incentive Compensation Clawbacks


Recent SEC enforcement actions serve as a reminder that CEOs and CFOs are subject to incentive compensation clawbacks under Section 304 of the Sarbanes-Oxley Act even when there has been no misconduct on their part.

Executive Compensation Clawbacks - Saba Software

In a February 2015 enforcement action, two former CFOs of Saba Software, Inc. agreed to repay bonuses and stock sale profits as a result of misstated company financial statements that the Division of Enforcement of the Securities Exchange Commission found had violated Section 304 of the Sarbanes-Oxley Act. This enforcement action follows two September 2014 enforcement actions against the former CEO and two former vice presidents of Saba Software based on the same restatements and compliance failures. Notably, the SEC required the former CEO and the former CFOs to reimburse Saba Software for an aggregate of approximately $3 million of bonuses as well as stock sale profits received during the periods of misstatements, even though neither the CEO nor either of the CFOs were charged with the misconduct that triggered the clawbacks.

The misconduct that led to material misstatements of Saba Software’s financial statements was two-fold. First, employees “pre-booked” professional service time by recording hours and billing customers for the performance of services before the company actually performed the services. Second, employees “under-booked” time by regularly failing to report professional services time worked to conceal overruns from their management and finance teams. The SEC found that the cumulative impact of these misstatements was roughly $70 million, and that this was material.

Clawbacks under Sarbanes-Oxley and Dodd-Frank

Clawbacks under Sarbanes-Oxley

Section 304 of the Sarbanes-Oxley Act requires a company’s CEO and CFO to reimburse the company for bonuses and other incentive compensation and stock sale profits if the company is required to restate its financial statements, as a result of misconduct, due to material noncompliance with the financial reporting requirements of the securities laws. Although the SEC’s enforcement practice during the first seven years after enactment of Section 304 was to bring clawback cases only where a CEO or CFO had been personally involved in the misconduct that resulted in a material misstatement, in 2010 the Enforcement Division began bringing Section 304 clawback cases without regard to the involvement of the CEO or CFO.

Although the SEC has the sole power to enforce clawbacks under Section 304, the number of public companies adopting clawback policies has increased steadily in recent years and these policies have become increasingly common among mid-cap companies. The ongoing adoption of clawback policies by public companies in advance of proposed SEC rules under Section 954 of the Dodd-Frank Act has been driven by proxy advisory firms, such as ISS and Glass Lewis, which consider clawback policies when making say on pay and other compensation-related voting recommendations. Shareholder proposals have also prompted companies to adopt clawback policies voluntarily.

Clawbacks under Dodd-Frank

The Dodd-Frank Act requires the SEC to adopt rules to implement the Act’s clawback provisions. Once proposed, final SEC rules will need to be adopted, and the stock exchanges must then propose and adopt final amendments to their listing rules. Once final stock exchange rules have been adopted, all listed companies will be required to adopt and disclose their clawback policies. Although the SEC has not yet proposed rules to implement Section 954, the Dodd-Frank Act established certain criteria for the scope and focus of the final rules. The final Dodd-Frank rules will supplement but not replace the existing clawback provisions of Section 304 of the Sarbanes-Oxley Act. 

Notable differences between the two clawback regimes are summarized in the table below:

  SOX Section 304 DFA Section 954
Misconduct  Restatement must result from misconduct

No misconduct required

Officers covered  CEO and CFO only All current and former executive officers
Compensation/profits covered  Any bonus and incentive-based compensation, plus profits from company stock sales Excess incentive-based compensation, including stock options awarded as compensation
Period(s) covered  One year following first public issuance or filing of the misstated financial statements Three years preceding the date on which the company files a restatement
Recovery of clawback  SEC enforces clawback through enforcement proceedings Company is required to recover any clawback

Implications of Saba Software

The SEC’s continued enforcement focus on Section 304 clawbacks serves as a reminder to all public companies that CEOs and CFOs may face compensation clawbacks under Section 304 even if they are not part of the misconduct that results in a misstatement. In fact, since 2010, SEC enforcement activity has been closely split between cases in which a CEO or CFO was personally involved in the underlying misconduct and cases in which they were not.

Saba Software also highlights the importance of maintaining strong internal controls and compliance programs to detect and prevent financial reporting risks. CEOs and CFOs who do not focus on internal controls and compliance procedures expose themselves to the risk that the SEC may find underlying misconduct in connection with a restatement, and then use Section 304 to claw back both incentive compensation and stock sale profits from such executives. As Robert Khuzami, Director of the SEC’s Division of Enforcement, stated in a 2012 enforcement press release, “[c]lawback of incentive compensation and stock sale profits as authorized under the Sarbanes-Oxley Act is yet another reason for CEOs and CFOs to be vigilant in preventing misconduct and requiring that companies comply with financial reporting obligations.” Jina Choi, the Director of the SEC’s San Francisco Regional Office, reinforced this point when she said, speaking about the Saba Software restatements in the SEC’s September 2014 press release about the CEO clawback, that “[w]eak internal controls create greater opportunity for accounting fraud, and investors are left holding the bag.”